Using Options to Bide Your Time

With the market slowing to a crawl, put time on your side with calendar spreads.
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What indifference a week makes. If anything, the

malaise and discontent I spoke of last week has only deepened as the issues confronting traders -- the election, rising interest rates, declining earnings growth and the ubiquitous orange cloud of terror -- continue to hang over the market as we enter the dog days of summer.

Option trading volume on Monday, the day we went on orange alert, was just 3.1 million contracts, the second-lightest day of the year. Only the Friday before Memorial Day generated less activity.

Unfortunately, this lack of options activity is a reflection of the low volume and disinterest plaguing the underlying market and it has bearish overtones for stocks in the near term. While bulls need growing volume and more new investment dollars to take prices higher, the bears know that stocks can fall of their own weight simply from a lack of demand. No volume is necessary.

In this environment, patience and safety should define your approach to trading. Thankfully, because recommending that traders simply stand aside is neither compelling reading nor helpful in generating profits, we have options to provide a large measure of both safety and profits. (Reading pleasure will probably remain elusive.)

Time Is Money

As volume is a weapon of the stock market, time is the option trader's double-edged sword. Knowing the impact and using theta to your advantage is one of the keys to choosing the right strategy, especially in a low-volatility, range-bound environment.

Peter Zomaya, an instructor with Optionetics, says, "Because the market will likely stay in a range, with the

S&P 500

trading between 1050 and 1100 between now and the election, it's a great time to buy calendar spreads." A calendar spread, sometimes referred to as a time spread, involves the sale of a nearby option with the simultaneous purchase of one option with the same strike price but a longer life span or expiration period.

The main advantages of buying an at-the-money calendar spread are that the sale of the near-term option reduces the effective cost of the longer-dated option purchased, it benefits from the acceleration of time decay in a market with little price movement, and it benefits from an increase in implied volatility.

The disadvantages are that the position suffers as the spread moves either deeper into the money or further out of the money, and a decline in implied volatility will also negatively impact the position.

Zomaya believes the recent selloff in drug and biotech stocks is presenting an attractive opportunity and suggests establishing a calendar spread in the

Biotech HOLDRs

(BBH) - Get Report

using call options that are one or two strikes out of the money. For example, with the Biotech HOLDRs currently trading at $135, one could sell the September $145 call and buy the January $145 call for a net debit of $4, or $400 per spread.

Of course, if you really think the market, a sector or even a specific stock will be going nowhere or has limited upside in the near term, you should sell premium or focus on positions that can be established for a net credit.

Tuesday's news

from carmakers

Ford

(F) - Get Report

and

General Motors

(GM) - Get Report

that they took massive incentives to reduce bloated inventories, and the outlook for diminishing demand in the face of raising interest rates, will likely prevent those stocks from working much higher in the near term. It should also keep a lid on the auto-parts suppliers such as

American Axle

(AXL) - Get Report

,

Lear

(LEA) - Get Report

and

Dana

(DCN)

. All of these are candidates for establishing bearish positions.

All of these stocks have already slid substantially over the past few weeks since their second-quarter earnings reports -- even though all posted strong second-quarter earnings, they provided a downbeat outlook for the second half of the year -- and may not have much more on the downside. So although I'm not certain about how much further they can decline, I feel comfortable they will be unable to mount a sustainable rally.

For this reason I would suggest selling a vertical call spread for a credit rather than buying a put spread for a debit. By selling the call spread (selling a closer-to-the-money strike and buying a further-out-of the-money call), the position can profit through time decay even if the stock price remains stagnant.

For example, with

Magna International

(MGA) - Get Report

-- one auto supplier that has not declined as much as the others I mentioned -- trading at $80.50, one can sell the August $80 call for $2 and buy the August $85 call for 25 cents, giving the sale of the spread a net credit of $1.75. This premium collected represents the maximum profit one can achieve if Magna shares are below $80 on the Aug. 20 expiration day. Buying the $85 call for a mere 20 cents, or $20 per contract, provides insurance that your maximum loss will be limited to $3.25 per spread if Magna suddenly rallies in the next two weeks.

As a comparison, a purchase of the August $80/$75 put spread would cost a net debit of $2 and provide a maximum profit of $3 per spread. While the risk is greater than the reward shorting the call spread, I feel more confident that Magna shares will not surpass their $81.75 break-even point on the vertical call spread than I do about the stock dropping to the put spread's $78 break-even point in the next two-week period. Also, given the short time frame and the nature of theta, I am much more comfortable having the wind of accelerating time decay at my back.

Generally speaking, with few immediate catalysts but a lot of longer-term uncertainty, it is wise to reserve the purchase of options -- whether it be put spreads or any position that requires movement in the underlying security to produce a profit -- to options with at least four months remaining until expiration. In any time frame shorter than two months, it might make sense to look at net credit or time spread positions.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.